Forward returns

So, I sit here with a good problem, I just had large cash infusion. I’m thinking that the SPX has been in a terrific run and has overperformed based on historical averages. Berkshire too has been in a great run. Should I park it in cash until we get some sort of setback in either?

Thinking we are on the cusp of an unfriendly fed and we will have some reversion to the mean.

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Why not buy some 12 - 30 month treasuries. Rates are perking up.

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We have bought maximum allowed on inflation bonds, the current yield is 7.12%. It is sad we could buy only 40K between me and my spouse.

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I just had large cash infusion. I’m thinking that the SPX has been in a terrific run and has overperformed based on historical averages. Berkshire too has been in a great run. Should I park it in cash until we get some sort of setback in either?

A couple of random thoughts.

It’s true that both the S&P and Berkshire have had great runs.
But their runs aren’t nearly of the same order…Berkshire is trading maybe 13-15% above its average valuation level since 2013, which is the same as its average since 2005.
So, round numbers, if the future resembles the past–
the downside you would rationally expect from overpaying would be something like getting a flat spot of no returns for maybe a year and a half. Possibly two.
That is not exactly the end of the world. You could buy today and not feel like you’ve done something fatally stupid.
Personally I’d wait for a dip in valuations, but that’s more about my personality than about what really matters.

As an example of lessons in valuation–
For anybody retired and living from selling Berkshire and thinking of selling some stock at today’s pleasant valuation levels,
one rational strategy would be to sell only enough stock for the amount of cash you’d expect to raise in 1.5 or 2 years…the rest of your stock will likely be worth more than today’s value in real terms when you ultimately sell it.
There is no need to sell more, even if today’s valuations are high.

The S&P 500, by contrast, is an astounding valuation levels compared to any kind of history, even just the last several years.
For example, it’s trading at about 2.99 times sales, and the average from just the last 10 years is 2.03 times sales.
Call it 50% above recent normal, and twice long run normal.
Using smoothed real earnings, it’s 38-48% overvalued compared to averages in the last 15,20,25, or 30 years.
Those very high valuation levels could certainly continue, but–
(a) Do you really want to bet on that?
(b) Even if valuation levels never fall, forward returns must necessarily be low from here.
Future aggregate earnings are finite. Pay more for the same value, get a lower return on your invested dollar.
Value ultimately comes from earnings.
Earnings can’t grow faster than sales over decent time frames.
Sales can’t grow faster than GDP over decent time frames.
GDP grows only so fast.
So, future value will rise only so fast.
Pay more for that unchanged stream of earnings, and you get a lower earnings yield–a lower return.
Ultimately, the trajectory of the value you gain from the index over time is tracked by the trajectory of the earnings yield underpinning it.

So, though the observation is correct that both BRK and SPY are both getting good valuations today,
the S&P seems to have a lot more air below it if we see anything like future valuation levels resembling recent averages.

Bottom line—there is always a case for some cash.
If you’re going to wait for a dip to buy at a better valuation level, it’s a lot more necessary strategy for the broad market than it is for Berkshire.

Good things to remember:
Don’t reach for yield. Only cash is cash. (generally including 3 month T-bills)
Don’t sweat the lack of returns and inflation erosion on the cash for a while.
First, FOMO is not a good thing.
And second, the return on cash is frequently excellent–if you count the improved long run returns from having it available to deploy when a good opportunity arises.

Jim

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Jim,

With the stretchy valuations of the US index and maybe fair valuation of Berkshire along side the huge risks to equities from black swans, interest rates, wars, environmental etc not to mention the speculative frenzy in electric car companies, meme stocks, crypto, NFTs etc… have you considered ‘left tail hedging’ or some kind of insurance should fear take hold?

The only thing I could find that made a lot of sense is Mark Spitznagel’s Universa Investments which seems to focus on keeping the cost of hedges low and getting explosive returns if the proverbial hits the fan. But I don’t think they are open to little guys.

The put premiums on things like

The S&P 500, by contrast, is an astounding valuation levels compared to any kind of history, even just the last several years.
For example, it’s trading at about 2.99 times sales, and the average from just the last 10 years is 2.03 times sales.
Call it 50% above recent normal, and twice long run normal.

And the reasons … free money for one, which appears to be coming to an end, at least temporarily.

But also look at some of the largest components of the S+P 500 - below actually from SPY -

Apple 7%
MSFT 6%
Google 4%
NVDA 1.7%
Meta 1.3%

So 20% is in companies with higher net margins (almost 100% profit on marginal sales in some areas) than ever before in the history of the US stock market. And more huge businesses like Tesla (2.4%) and AMZN (3.7%) with maybe a tad lower profit per marginal sale. Hence a higher proportion of GDP going to profits overall.

Will the proportion of such super-scaled businesses value in the S+P 500 continue to increase?

Or will monopoly/competition legislation such as the EU and China are enacting bring them to earth?

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If you have patience, and nearly no one does as envy is by far more prevalent…

This is the best advice:

Good things to remember:
Don’t reach for yield. Only cash is cash. (generally including 3 month T-bills)
Don’t sweat the lack of returns and inflation erosion on the cash for a while.
First, FOMO is not a good thing.
And second, the return on cash is frequently excellent–if you count the improved long run returns from having it available to deploy when a good opportunity arises.

Jim

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Given the risks described in these two articles, perhaps it’s a good idea to invest some fund in the emerging markets which are better priced than the US market:

“Goldman Sachs warns the dollar is at risk of losing its dominance, and could end up a lesser player like the UK pound”
https://finance.yahoo.com/news/goldman-sachs-warns-dollar-ri…

“Dimon says confluence of inflation, Ukraine war may ‘dramatically increase risks ahead’ for U.S.”
https://www.cnbc.com/2022/04/04/jamie-dimon-says-inflation-u…

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Don’t reach for yield. Only cash is cash. (generally including 3 month T-bills)
Don’t sweat the lack of returns and inflation erosion on the cash for a while.
First, FOMO is not a good thing.
And second, the return on cash is frequently excellent–if you count the improved long run returns from having it available to deploy when a good opportunity arises.

I have just under 10% of assets in VAIPX. I thought inflation is something I should protect this money from. Do you think that’s a poor selection? This is in tax advantaged accounts, so it’d be easy to change my allocation. The other thing I considered doing was selling cash covered puts for 5% to 10% above book value, selling them about 6 months before expiration. I figure this could get me around 2.5% to 2.75% on my cash. Again it’s in a tax advantaged account, so the puts have to be cash covered.

I have just under 10% of assets in VAIPX. I thought inflation is something I should protect this money from.
Do you think that’s a poor selection? This is in tax advantaged accounts, so it’d be easy
to change my allocation

Beats me.
But yields on inflation-protected paper are negative out to 20 years.
It hardly seems like the best pick in the world, nor the best place to go hunting.
And it’s not like it gives you perfect protection. Total return -5% in less than a month.
Though admittedly at 10% of your portfolio, few things are worth losing too much sleep over either way.

If I felt I had to deploy my cash pile right away (I don’t feel that way), then I’d probably pick a slate of profitable firms with a couple of simple quant criteria.
Intel has a forward earnings yield of 7.5% and a current dividend yield over 3%.
Both of those are in effect inflation protected so long as the business doesn’t die, and a formidable balance sheet.
How badly could a slate of such things do?

Possible inspiration. https://boards.fool.com/a-spy-alternative-screen-34516863.as…
The “with dividend” version of that screen has beat the S&P by 5.1%/year in the 22 months since the post, to March 7. (31.1%/yr versus 25.7%/yr)
And every pick is a high-ROE cash rich large cap paying a dividend. Not the usual place to find dangerous disasters. Lower stock concentration risk than the S&P.
Early days, but it hasn’t yet taken the opportunity to blow up, which is nice.

Right now I have (ahem) quite a bit of cash.
Some of which I’m paying a negative interest rate on, as it’s in euros, so I’m slowly losing purchasing power, happily biding my time.
Avoiding this temptation https://bruceturkel.com/wp-content/uploads/2019/10/Patience-…

Jim

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Thinking we are on the cusp of an unfriendly fed and we will have some reversion to the mean.

It all depends on your time horizon. No one knows what happens in the short-term, but in the long-run 3 to 5 years, my expectation is markets will be up.

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The S&P 500, by contrast, is an astounding valuation levels compared to any kind of history

For example, it’s trading at about 2.99 times sales, and the average from just the last 10 years is 2.03 times sales.

Well, why would it matter? It will matter if your margins are same and your price to sales increases. Is SP500 Gross and operating margins same as 10 years ago?

I understand the mean reversion argument, but sometimes structurally few things change. If you take the top 15 companies in sp500, they carry higher gross and operating margin than any other time I could think of. Apple, Microsoft, Google, FB are very high margin business.

Instead of looking at price to sales, I would look at margin and price to EBITDA or operating profit would be a better number to look at.

Using smoothed real earnings, it’s 38-48% overvalued compared to averages in the last 15,20,25, or 30 years.

Earning increase over time and interest rates are lower compared to 15, 20, 25, 30 years. In 1990 we had 8% 30 year UST and 2000 we had 6% 30 year uST, even in 2008/2009 we had 4.5% and today we have 2.5%.

Unless you expect rates are going back to 4%, 5%, 6% o 8%, in which case one should be comfortable to short the market, we should factor interest rates in to the valuation.

Even if valuation levels never fall, forward returns must necessarily be low from here.

Can someone remind me why anyone is entitled to 15% return when your risk free rate is < 3%.

Sales can’t grow faster than GDP over decent time frames

But is it true for SP500? What may be true for the entire economy may not be true for handpicked 500 top companies. I mean how many times we heard Amazon cannot grow faster than retail???

So, though the observation is correct that both BRK and SPY are both getting good valuations today,
the S&P seems to have a lot more air below it if we see anything like future valuation levels resembling recent averages.

Let us flip this a bit. When are we going to ask why Berkshire, a GEM with outstanding operating business, with genius capital allocator is perennially undervalued than the average sp500 company? or Perhaps it is not?? If you remove few really high valued companies out of the index, than Berkshire valuation may not be any different than the rest of the index?

First, FOMO is not a good thing.

IS FOMO relevant here? If you have cash, and you have a relatively long-term horizon, why not invest over a period of time and build the portfolio? Just asking…

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Jim:

The “with dividend” version of that screen has beat the S&P by 5.1%/year in the 22 months since the post, to March 7. (31.1%/yr versus 25.7%/yr)
And every pick is a high-ROE cash rich large cap paying a dividend. Not the usual place to find dangerous disasters. Lower stock concentration risk than the S&P.
Early days, but it hasn’t yet taken the opportunity to blow up, which is nice. .

I was wondering if you chose the basket of 40 stocks now using the same criteria as before will they be very different? If I understand it correctly, the original basket grew 31.1% a year so far, although the future performance may not be as good. Was the basket made of shares of equal weight?

As I do not have the resources for working out the constituents of the basket I intend to use the one presented by you 22 months ago. Since the approach is not exact a small variation should not matter, I think.

I have not read all the posts that followed your original post. I hope my understanding of the performance is correct.

Cheers.
alpha

For example, it’s trading at about 2.99 times sales, and the average from just the last 10 years is 2.03 times sales.

Just to belabor the point, traditionally companies carried debt anywhere between 50% of EV to multiples of operating earnings. Now companies carrying 10’s of Billions in cash and some carry as much as 100’s of billions in cash. MSFT, GOOGL, BRK all carry over 100 billion cash. Imagine that.

Instead of doing price to sales, let us do EV to sales. May be that may not show such an outrageous over-valuation!!! Well, I know Jim, doesn’t care about the cash on the balance sheet (except when it is in Berky’s BS)or …

Either you can seek truth or you can tell a story…

I was wondering if you chose the basket of 40 stocks now using the same criteria as before will they be very different?
If I understand it correctly, the original basket grew 31.1% a year so far, although the future performance may not be as good.
Was the basket made of shares of equal weight?

Yes, the idea is to buy equally sized positions.
But that isn’t the return from holding the original picks.
The portfolio is reconstituted regularly.

Though there are lots of ways to go about it, the specific strategy recommended and tested since then goes like this:
Figure out what all the current picks would be, and rank them in order.
Buy equal dollar amounts of the top 40 in the list.
Hold for two months, reinvesting any dividends received in the stock that paid the dividend.
At the end of two months, calculate again from scratch what today’s picks would be, and rank them in order.
Sell any stocks you currently own which are no longer ranked in the top 45, and replace them with the highest ranked stocks you don’t already own.
Repeat.
Once a year (every sixth portfolio reconstitution event), rebalance all positions to equal weight.

The reason for the “buy top 40, sell only below rank 45” complication is that it simply cuts down on needless trading.
There is no point selling rank 41 to buy rank 40; they’re statistically indistinguishable.
Every two months you’d be replacing only about 2.1 of the 40 stocks—these selection criteria change very slowly.

For the “with dividend” version, I think these would be the picks for the first week of March:
MSFT SONY TSM CSCO ACN NVDA COST TROW BBY NKE
INFY ERIC TXN SPGI AMP AB NTAP INTU LOGI EXPD
DKS WSM NVO STM TER HLI SEIC KLIC LRCX ODFL
MPWR RHI BIG MKTX AOS WWE PIPR FHI IPG TSCO

25 of these 40 were also in the top 40 a year earlier.

The other variation which does not require a dividend has a stronger large-cap bias and therefore tracks the S&P 500’s direction much more closely over short time frames.
That might be something you like, or not, depending on your proclivities.
The top 40 picks for that version for early March were:
GOOG MSFT FB CSCO MRNA ACN VRTX NVDA COST TROW
MOH TJX BBY NKE REGN AMD TXN SPGI ROST INCY
AMP MELI NTAP FTNT LOGI EXPD DKS WSM LULU DECK
HZNP CMG TER NVR HLI ULTA BIO ABC AJRD QDEL

These lists are just to get a feel for what sort of stocks the strategy would pick.
As mentioned above, the list would be reconstituted regularly, so the portfolio would change somewhat over time.

Jim

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Thanks Jim.

I have to see if I can follow the procedure in full with periodic updates as outlined by you, else it will become a different procedure and may not be as successful.

Cheers.

I have to see if I can follow the procedure in full with periodic updates as outlined by you, else it will become a different procedure and may not be as successful.

If you want to know if a variation or simplification still worked about as well in backtest, let me know.
If it’s easy, and you catch me on a good day, I can check.
Whether it works in real life is up to the gods on Olympus; I can’t answer that one.

The general decisions to make:
There are two ROE data fields you can use, quarterly and annual.
It works a pinch better in backtest with the quarterly figures, but there is a fair bit more turnover in the portfolio.
More trading, tax implications for some people.

There are also two versions of the screen: any big stock OK, or requiring that every stock be a dividend payer.
The first one leans more towards super-large-cap, and backtests with slightly lower returns.
The with-dividend-required variant makes a bit more money in backtest, but it depends a lot on your preference (and tax rate) for dividends.
This one will diverge a little bit more from the index performance over short time frames. Some people don’t enjoy that, though it isn’t important.

In any case—
On the surface of things, it seems unlikely one would do TOO badly over time with a diversified slate of big cash-rich high-ROE firms.

Jim

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Jim:

In any case—
On the surface of things, it seems unlikely one would do TOO badly over time with a diversified slate of big cash-rich high-ROE firms.

How true!

I just did a relatively trivial exercise with 19 stocks listed in your post of 5/24/2020, excluding SNE which is no longer a valid symbol. I worked out the prices on 5/26/20 (5/24 was a Sunday and 5/25 the Memorial Day) from Yahoo - I am still looking for an app that will give the price once the symbol and date are input.

I chose a starting investment of about $30,000 for all these stocks to arrive at the number for each.

I was quite surprised to see a gain of more than 63% at the time of writing. Only FB and BABA had a negative return. The gains ranged from 200% for NVDA to 3% for VRTX with AAPL having a gain of 124%, GOOG 100% and AMZN 36%, to name a few.

I would love to transform the Watch List I prepared on my Fidelity account to a form that can be shared here on the Fool site, but I don’t think it is possible. I am not very good in preparing tables for message Board Posts but may pick up enough energy to share with others the very interesting result (in my view) I have found.

Cheers
alpha

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I should have added that the gain of 63% over 1.86 years represents about 30% CAGR.
[1.30**1.86 = 1.629]